"Politics is supposed to be the second oldest profession. I have come to realize that it bears a very close resemblance to the first."
- Ronald Reagan
As they tend to do with remarkable frequency, politicians and regulators have become involved in various markets around the world over the past week, and the results have not been pretty for the most part.
Here is just a sampling of their handiwork. In Europe, Greece's fiscal problems (their own creation) were compounded by statements out of the ECB and Germany that some took to mean a possible expulsion of Greece from the EMU, possibly a breakup of the EU itself. While that is possible, it is not probable in the near term and those statements only served to exacerbate an already delicate situation. In China, recent actions and statements made it clear that China is concerned about the formation of asset bubbles and intends to curb liquidity and ultimately raise rates in an effort to cool growth before inflation gets out of control. Markets have overreacted to what are essentially reasonable steps.
Regulators in the UK and the U.S. appear set to wage war on the banking sector. President Obama, fresh from his election loss in Massachusetts, wants a partial return to the Glass-Steagall Act. He wants banks to stop proprietary trading and not sponsor or invest in private equity funds. In the UK Alistair Darling, the UK finance minister, proposed a 50-percent levy on discretionary bonus payments to curb big bank bonuses. Finally, as of last week, Congress is investigating Timothy Geithner's role in the AIG bailout and is threatening to deny Ben Bernanke a second term.
The result of all of this, coupled with mixed earnings results and some cautious guidance from companies, has been a sharp deterioration in sentiment and with it a reduced willingness to take risk. It is completely reasonable, in my opinion, for markets to react the way they have. The prospect of reduced earnings and greater regulatory oversight for banks, together with political uncertainty in the U.S. and Europe, make for an unappetizing combination. I do think the reaction to China's actions may be overdone; bear in mind that China grew at 10.7 percent last quarter, which is far removed from the 0 to 2 percent growth most developed economies are anticipating for much of 2010. That is a situation most countries can only dream of and, should they find themselves in that situation, they would probably do exactly as China has done.
So what is an anxious currency investor to do? What are the least tainted and the least toxic currencies in this environment? Clearly the renminbi is one, but for the most part, not an investment option for offshore investors. The yen is back in favor, but not for positive reasons. As markets have fallen, so have global interest rates, which has reduced the yield disadvantage for the yen and caused it to strengthen versus most currencies. The dollar has benefited as well, but in my opinion not for well-founded reasons. Should Obama's plan for banks come to pass and should Bernanke fail to get reappointed, the dollar could be in for rough sledding. Banks will undoubtedly lose earnings power, which will mean that equity will take longer to rebuild. That will put even greater constraints on lending and, therefore, economic growth. It will drive risk capital — and therefore growth — to other markets. That augurs well for commodities and for those currencies that benefit from the flight of risk capital from our markets.
Europe is clearly not in better shape. Apart from the problems in Greece and the rest of the PIGS (Portugal, Ireland, Greece and Spain — an unfortunate but appropriate acronym), growth is expected to be tepid at best in 2010 and beyond and the currency is still somewhat overvalued.
Assuming things stay as they are, I see the commodity currencies rebounding first, followed by the stronger emerging market currencies once risk appetite stabilizes. Canada, Australia, Norway and others had been doing better than most and are likely to again, especially if the dollar sells off and boosts the dollar price of the commodities they export. The emerging market list is led by the BRICs (in sharp contrast to the PIGS). In the near term, the dollar and especially the yen will remain in favor, but the longer-term justification for their strength seems somewhat weak. I was one of many that had expected a generally stronger dollar this year, but Obama and Congress have changed my mind.
Of course, it is possible that there will be changes to the initial plan to reform banks, while Greece will get their finances in order and the world will come to terms with China's actions. I think it is unlikely that everything will be resolved neatly in the near term, but time will tell. In the interim, we will have to live with more uncertainty and volatility, but that is what makes currency markets fascinating — and why most forecasters are generally wrong.
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